Archive for December 21st, 2009

To modernize an outdated Congressional budget process in light of the daunting economic challenges facing the nation, the Peter G. Peterson Foundation, The Pew Charitable Trusts and the Committee for a Responsible Federal Budget have launched a landmark partnership to build bipartisan consensus for a core set of reforms. The Peterson-Pew Commission on Budget Reform has convened the nation’s preeminent experts to make recommendations for how best to improve the nation’s fiscal future and how best to strengthen the federal budget process.

Michael Bordo and Harold James have written a super paper comparing Great depression with this crisis. Though there have been many papers on this track, anything extra from Bordo and James is always welcome. Both are exceptional economic historians.

Unfortunately, the paper is a paid NBER version. I am yet to find a free version.

This paper examines three areas in which analogies have been made between the interwar depression and the financial crisis of 2007 which reached a dramatic climax in September 2008 with the collapse of Lehman Brothers and the rescue of AIG: they can be labeled macro-economic, micro-economic, and geo-political. First, the paper considers the story of monetary policy failures; second, there follows an examination of the micro-economic issues concerned with bank regulation and the reorganization of banking following the failure of one or more major financial institutions and the threat of systemic collapse; third, the paper turns to the issue of global imbalances and asks whether there are parallels that might be found in this domain too between the 1930s and the events of today.

The big difference in this paper is also gives a European perspective on the GD. Much of the papers only give US side of the story. This one has case studies from Germany and Austria as well.

What is particularly interesting is Germans were quick to act to falling banks and was seen to have efficient policies – bad banks, reorganization and merging of banks, buying bills from banks as interbank money markets had frozen etc. So today’s policies are anything but modern. It was all tried earlier as well.

However, just like today, the bailouts became controversial as they were seen as socializing losses and initial bailouts were seen as helping politicians and their constituencies. Same was seen in Austria as well where bailouts were seen as massively corrupt. There was a big public hostility to bailouts just like today.

The authors then raise concerns of growing nationalism as happened in GD. The authors say China has reasons to close itself more to the rest of the world.

Daniel L. Thornton of St Louis Fed in a short paper makes a case for inflation first monetary policy. There is a big discussion post-crisis on what should a central bank target – inflation, growth, financial stability etc.

He says monetary policymakers must pursue a hierarchical target with price stability at tops

I argue that there are several reasons central banks might want to operate under what Laurence Meyer calls a “hierarchical mandate,” that is, where the principal objective is price stability and policymakers do not pursue economic stabilization policy unless their price stability objective has been achieved.

Reasons:

The first reason monetary policymakers might be well served to operate under a hierarchical mandate is that changes in the money supply have no long-run effects on the economy.

The second reason is that the policy option faced by policymakers is a function of the structure of the economy, the source of the shock, and whether the shock is temporary When faced with a supply shock, an attempt to mitigate its effect on prices exacerbates the effect on output and an attempt to mitigate its effect on output exacerbates the effect on prices. A hierarchical mandate would alleviate concerns that policymakers might jeopardize their long-run price stability objective for some short-run gain in economic stability because of political pressure or for other reasons.

Finally, policymakers might prefer a hierarchical mandate because the more firmly anchored are inflation expectations, the more aggressively policymakers will be able to pursue economic stability.

Though am not sure whether there will be many takers for this inflation first idea.Before crisis, the basic idea was that price stability is a necessary condition (some even thought it as sufficient condition as well) for financial stability. Hence focus was on price stability and pre crisis inflation levels were really stable and non-volatile. Hence, it was thought that financial markets are stable as well. Central Bankers either just practiced price stability or asked others to follow it.

We all know what followed was anything but stable.

What is also ironical is how quickly price stability became a vogue. Just after Volcker showed in late 1970s that inflation could be tamed by monetary policy all central banks jumped onto it. But think about financial instability. It has been there since ages but nobody wants to do something meaningful in this area.

This does not imply price instability can be tolerated. Price Stability is a very important goal. But financial stability is a very important objective as well. You cannot ignore it anymore.

Whether central banks like it or not they will always be responsible for financial stability. One major reason is central banks act as lender of last resort. So in case of any problem in fin markets the attention is always going to be on central banks. So, it is always better to give them proper responsibility. They should be given more tools apart from interest rates to manage financial stability. The tools should be sharper and not just involve writing financial stability reports (or issuing sermons as Mervyn King calls it).

I don’t think hierarchical mandates would work. Price Stability and Financial Stability would go hand in hand. This makes things complicated but that is reality for you. We were thinking monetary policy is so simple (again boring as Mervyn King called it)- just look at price stability. Economics is pretty complicated and policymaking is also going to be complicated.

It is useful to simplify things but not oversell it. I think everything was oversold before this crisis – inflation targeting, price stability, monetary policy only, efficient financial markets etc.